Question

Explain how the Keynesian sticky wage model is built. What are the main relationships? Explain briefly what each curve depicts.

Answer 1

In the keynesian sticky wage model, wages are assumed to be sticky or inflexible in the short run. This is because the long term contracts set the wages. So, the wages require time to adjust as per the inflation. There can be some contract or agreement between firm and worker that can restrict the wage to change in the short run.

The model is built on the observations of changes in prices when nominal wages are fixed. Let say there is an increase in the general price level. Since, the real wage = W/P

where W = Nominal wage

An increase in the price level will lower the real wage of the workers making the labor services cheaper. Since, the real wages are the cost of production for the firm, decline in such cost would make the firm to hire more workers at lower wage. So, more labor means more employment and more output level.

Labor Demand function = Ld(W/P)

It is a downward sloping function which implies that lower wages increases the demand and hiring of additional labor.

Output function, Y = f(L). It states that more labor induces more output.

Following equations shows the AS curve:

Y = Ybar + alpha(P - Pe)

where Ybar = natural rate of output

Pe= expected price.

This equation shows that output deviates from its natural rate when there is deviation in the actual price and expected price level.

Short run AS curve is upward sloping showing a positive relation in price and output level. Since, wages are fixed, the output level continues to increase with increase in price level.

All these functions/curves are depicted in the below figure:

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